How To Identify Neglected Stocks

In an earlier article we discussed the Neglected Firm effect and its ability to consistently deliver superior risk-adjusted returns. The idea of a generic stock, its link with information deficiency and the prospect of a ‘free lunch’ over an extended period in the stock market were briefly explored. In order to offer practical suggestions on how to implement the ‘generic investment idea’ strategy, it is essential to present a roadmap that outlines where we are headed, the consequences of going down this route and the sequence in which we move forward. Before adopting any investment strategy, it is essential to identify the primary investment objectives in an explicit manner. Typically, these objectives need to take account of the investor’s time horizon, desire for liquidity and level of acceptable risk. Investing in generic stocks is likely to result in a situation where:

• Information is far less continuously available on a convenient basis, and is typically of poorer quality.
• There is hardly any consensus among analysts or other investors on the outlook for such stocks, which can prove very dispiriting.
• The universe typically includes a higher proportion of smaller companies which tend to be less liquid.
• The safety net of a comforting dividend yield is usually absent.

A relevant concern therefore is to identify the minimum level of information (quantity and quality) that allows you to sleep well at night. It also highlights the amount of effort the investor should be willing to put in to achieve the ‘minimum information threshold’. Finally, the need for diversification as a means of risk-reduction becomes absolutely vital.

The next step is putting together a plan to reliably identify neglected stocks. The major issues here are:

• All measures of neglect are fundamentally proxies rather than exact indicators. Consequently, it is essential to supplement the data with experience and judgement.
• Measures of neglect are relative yardsticks vis-a-vis other stocks as well as over time.
• There is a need for constant review and monitoring to validate the degree of neglect.
• Finally, experience suggests that it is best to use different measures to maximise ‘neglect confirmation’.

By far, the two most reliable indicators of neglect are the number of institutional investors that own the stock (banks, insurance companies, mutual funds and FIIs) and the extent of research coverage by analysts. In each case, lower is better. The point to note is that limited institutional ownership is not necessarily a negative. What matters is the proportion of the free float that is owned and the number of such owners. Typically, if institutions own less than 10 percent of the free float and there are three or fewer owners, it is a reasonable proxy for neglect. As a rule of thumb, if less than five analysts cover the stock and provide earnings forecasts, you are justified in assuming neglect. Apart from these bellwether metrics, low daily traded volume relative to its peers and its own trading history is a fairly efficient neglect confirmation technique. Limited press coverage and the absence of analyst meets are also signs one should look for. A critical element in implementing this strategy is doing a really thorough job of verifying neglect. The importance of using overlapping measures and double-checking with additional sources such as brokers, bankers and journalists is crucial in confirming neglect.

Once you have put together an extensive list of generic stocks, the next step is to put them through a sieve. The screening is useful in identifying stocks with high financial risk. Stocks that are vulnerable to the risk of bankruptcy need to be rejected since their neglect is well deserved! Secondly, you want to avoid ‘perma-sleepers’, given the time value of money. In fact, the ideal generic investment is a neglected stock of a solid company that springs to life shortly after purchase because of the existence of a set of factors that appeal to a broader base of less picky investors. So, not only do you wish to avoid the lemons, you wish to anticipate a change in popularity. These ends can be accomplished by applying a combination of two methods: (a) rigorous filters, and (b) diversification. Since we are dealing with a group of stocks that share neglect driven by information deficiency, it is not possible to eliminate risk solely through diversification. The need for intelligent screening to achieve superior returns has no substitute.

Effective portfolio construction therefore requires a trade-off between the two alternatives. The ideal mix depends on information availability, the investor’s expertise, the amount of time and resources available and most importantly, personal temperament and super-ordinate objectives. In practice, a portfolio of 12-15 stocks gets rid of more than 90 percent of ‘diversifiable’ risk. The real issue is identifying high-quality filters that do not consume excessive time and resources.

The attempt to eliminate bankruptcy risk leans heavily on multivariate prediction models, among which Altman’s Z-Score is probably the best known. While such models are robust, they are difficult to construct and extremely data-intensive. Experience suggests that less complicated financial ratios that are easily obtained from financial statements work almost as well. One such ratio that is dependable, easy to understand and has predictive value is the ratio of operating cash flow to total debt. The rationale for its efficacy is that it captures the ability of the company to repay its outstanding liabilities without having to resort to external financing.

Having reached this far, you have hopefully knocked off the lemons. But to succeed in the market it is not enough to simply avoid disaster. The next challenge in putting together the generic stock portfolio is to stay away from over-valued stocks and reject companies that are fairly priced but unlikely to appreciate given the mediocrity of their underlying business. The first set of filters, which are also easy to implement, emphasise the opportunity for growth and its valuation relative to the peer group. Subsequent filters seek to identify financial solidity and the long-term attractiveness of the business. The stepwise screening process is the closest one can get to finding diamonds in the rough! Stocks that fail to meet even a single screen are eliminated immediately. If the final list is not extensive enough to permit judicious diversification (less than 12 stocks), the conclusion may be either not to invest or relax the screening criteria to take on a higher level of risk. A what-if analysis of checking the sensitivity of end results to marginal changes in the filters is always helpful. The recommended filters, and the order in which you implement them, are listed below:

• Compounded annual EPS growth in excess of 15 percent (a proxy for nominal GDP growth) over the past decade.
• Current PE ratio not in excess of normalised PE trading band. This one needs a bit of explanation and a fair amount of effort! Calculate the ‘normalised PE’ for the last 5 years by using the average of the high and low price for the year and dividing that value by the annual EPS. Now compute the average of this annual PE for the past 5 years and you have a crude normalised PE. If the current PE is clearly higher than the normalised PE, either the stock is over-priced or the popularity flow is already a work in progress!
• Current financial leverage of less than 50 percent (total debt as a proportion of net worth).
• Consistent growth in revenues during the last 5 years.
• Five-year average return on equity in excess of 18 percent (an estimated cost of capital for smaller companies).

If you completed this process, you now stand on the brink of success. Just a few more points to keep in mind in case you opt to generic: What is the most sensible way to review and monitor the portfolio and how do you judge the right time to exit individual holdings? The final article will come to terms with these nuances and offer a shortlist of generic stocks that make the cut in the current environment.

Sanjoy Bhattacharyya is a partner at Fortuna Capital

Disclosure: This column is neither an offer to sell nor solicitation to buy any of the securities mentioned herein. The author frequently invests in the shares discussed by him.